How is interest calculated on heloc vs mortgage

A Home Equity Line of Credit (HELOC) allows you the flexibility of making interest-only payments for the first 10 years. How much would those payments be, and what impact would choosing to make additional principal payments have on your overall loan balance?

Information and interactive calculators are made available to you as self-help tools for your independent use and are not intended to provide investment advice. We cannot and do not guarantee their applicability or accuracy in regards to your individual circumstances. All examples are hypothetical and are for illustrative purposes. We encourage you to seek personalized advice from qualified professionals regarding all personal finance issues.

What is a home equity line of credit?

A home equity line of credit, or HELOC, is a second mortgage that gives you access to cash based on the value of your home. You can draw from a home equity line of credit and repay all or some of it monthly, somewhat like a credit card.

With a HELOC, you borrow against your equity, which is the home’s value minus the amount you owe on the primary mortgage. You can also get a HELOC if you own your home outright, in which case the HELOC is the primary mortgage rather than a second one. When you’re shopping around for a loan, borrowing from the equity in your home will often get you the best rate.

Key Takeaways

• You typically have 10 years to withdraw cash from a home equity line of credit, while paying back only interest, and then another 20 years to pay back your principal plus interest.

• Unlike most loans, your rate will likely change based on market conditions over the life of the credit line.

• In order to qualify for a home equity line of credit, lenders will usually want you to have a credit score over 620, a debt-to-income ratio below 40% and equity of at least 15%.

• Most HELOC lenders will let you borrow up to 85% of the value of your home (minus what you owe), though some have higher or lower limits.

• Since you risk losing your home if you can’t pay back your loan, a home equity line of credit is best reserved for expenses that will help build wealth (like home improvements and renovations) and for those who want to bolster their emergency funds.

• A HELOC isn’t an appropriate way to finance vacations or depreciating assets like cars, and it wouldn’t be the best fit for someone who plans to sell their home in the near future.

How a HELOC works

Much like a credit card that allows you to borrow against your spending limit as often as needed, a HELOC gives you the flexibility to borrow against your home equity, repay and repeat.

Most HELOCs have adjustable interest rates. This means that as baseline interest rates go up or down, the interest rate on your HELOC will adjust, too. However, because a HELOC is secured against the value of your home, the interest is typically closer to a mortgage rate than it is to a credit card rate.

To set your rate, the lender will start with an index rate, then add a markup depending on your credit profile. Generally, the higher your credit score, the lower the markup. That markup is called the margin, and you should ask to see the amount before you sign off on the HELOC.

HELOC requirements

Lender requirements will vary, but here's what you'll generally need to get a HELOC:

• A home value that’s at least 15% more than you owe.

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How to get a home equity line of credit

The process of getting a HELOC is similar to that of a purchase or refinance mortgage. You’ll provide some of the same documentation and demonstrate that you’re creditworthy. Here are the steps you’ll follow:

4. Once you have pulled together your documentation and selected a lender, apply for the HELOC.

5. You’ll receive disclosure documents. Read them carefully and ask the lender questions. Make sure the HELOC will fit your needs. For example, does it require you to borrow thousands of dollars upfront (often called an initial draw)? Do you have to open a separate bank account to get the best rate on the HELOC?

6. The underwriting process, though not as extensive as when you got your mortgage, can take weeks.

7. The final step is the loan closing, when you sign paperwork and the line of credit becomes available.

🤓Nerdy Tip

Don't assume that the price you paid at closing is what your home is worth. During underwriting, your lender may order an appraisal to confirm the home's value. If home prices in your area have appreciated while you've owned your home, you'll also have more equity, as the difference between the property's higher value and the amount remaining on your mortgage will be larger.

How much can you borrow?

The maximum amount of your home equity line of credit will vary based on the value of your home, what percentage of that value the lender will allow you to borrow against and how much you still owe on your mortgage. Two quick calculations can give you an idea of what you might be able to borrow with a HELOC.

Your home's current value x Percentage of value lender allows you to borrow = Maximum amount of equity that could be borrowed

Maximum amount of equity that could be borrowed - Remaining balance on your mortgage = Total amount you can borrow

Say you have a home currently worth $300,000 with a balance of $200,000 on your first mortgage, and your lender will allow you to access up to 85% of your home’s value. Multiplying the home's value ($300,000) by the percentage the lender will allow you to borrow (85%, or .85) gives you a maximum amount of $255,000 in equity that could be borrowed. Subtract the amount you still owe on your mortgage ($200,000) to get the total amount you can borrow with a HELOC — $55,000.

Or skip doing the math, and use the HELOC calculator below to see how much you might be able to borrow.

How you pay back a HELOC

A HELOC has two phases: the draw period and the repayment period.

Draw period: During the draw period, you can borrow from the credit line by check, transfer or a credit card linked to the account. Monthly minimum payments often are interest-only during the draw period, but you can pay principal if you wish. (Be aware that if you make only interest payments during the draw period, your monthly payments during the repayment period will be substantially larger.) The length of the draw period varies; it’s often 10 years.

Repayment period: During the repayment period, you can no longer borrow against the credit line. Instead, you pay back the loan in monthly installments that include principal and interest. With the addition of principal, the monthly payments can rise sharply compared with the draw period. The length of the repayment period varies; it’s often 20 years.

At the end of the loan, you could owe a large lump sum — or balloon payment — that covers any principal not paid during the life of the loan. Before you close on a HELOC, consider negotiating a term extension or refinance option so that you're covered if you can't afford the lump sum payment.

🤓Nerdy Tip

If you plan to move any time soon, a HELOC may not be the right choice for you. When you sell your home, you’ll have to pay off the balance of the HELOC (after all, you can't borrow the equity of a home you don't own). Paying off the home equity line of credit could cut into any profits you might be making from your home's sale. You might also have to pay a cancellation fee to the lender.

Is getting a HELOC a good idea?

Whether a home equity line of credit is a good idea really comes down to your goals and financial situation. A HELOC is often used for home repairs and renovations, which can increase your home's value. Another bonus: The interest on your HELOC may be tax-deductible if you use the money to buy, build or substantially improve your home, according to the IRS.

Some use home equity lines of credit to pay for education, but you may get better rates using federal student loans. Financial advisors generally don’t recommend using a HELOC to pay for vacations and cars because those expenditures don’t build wealth, and may put you at risk of losing the home if you default on the loan.

Disadvantages of a home equity line of credit

The main drawback of a HELOC is that it increases the risk of foreclosure if you can’t pay the loan. Regardless of your goal, avoid a HELOC if:

Your income is unstable. If it’s possible that your income will change for the worse, a HELOC may be a bad idea. If you can’t keep up with your monthly payments, your lender could force you out of your home.

You can’t afford the upfront costs. A HELOC may require an application fee, title search, home appraisal, real estate attorney fees and points. These charges can set you back hundreds of dollars.

You aren’t looking to borrow much money. A HELOC's upfront costs may not be worth it if you need only a small line of credit. In that case, you may be better off with a low-interest credit card, perhaps with an introductory interest-free period.

You can’t afford an interest rate increase. HELOCs have adjustable rates. The loan paperwork will disclose the lifetime cap, which is the highest possible rate. Could you afford a monthly payment with that much interest? If not, think twice about getting the loan.

You’re using it for basic needs. If you need extra money for day-to-day purchases and you’re having trouble just making ends meet, a HELOC isn’t worth the risk. It’s safer to get your finances in shape before taking on additional debts.

Variable rates leave you vulnerable to rising interest rates. Be sure to take this into account. Look at the size of the periodic cap (that's how much the interest rate can change at any one time) and the lifetime cap (the highest interest rate you could be charged over the life of the loan) to get an idea of how high your payments could get.

On the plus side, as with a credit card, you pay interest only on the amount of money you use, not the total credit line available to borrow.

Getting the best HELOC rate

This one’s on you: The more you research, the bigger your reward. As you look for the best HELOC rates, get quotes from various lenders. Check your primary bank or mortgage provider; it might offer discounts to existing customers. Get a quote and compare its rates with at least two other lenders. As you shop around, take note of introductory offers like initial rates that will expire at the end of a given term.

How a HELOC affects your credit score

Although a HELOC acts a lot like a credit card, giving you ongoing access to your home’s equity, there’s one big difference when it comes to your credit score: Some bureaus treat HELOCs of a certain size like installment loans rather than revolving lines of credit.

This means borrowing 100% of your HELOC limit may not have the same negative effect as maxing out your credit card. Like any line of credit, a new HELOC on your report will likely reduce your credit score temporarily. However, if you borrow responsibly — making timely payments and not utilizing the full credit line — your HELOC could help you improve your credit score over time.

What to do if you can’t keep up with your HELOC payments

Since most HELOCs have an adjustable rate, it’s possible that your payments could exceed what you’d originally planned. If you can’t pay back what you’ve withdrawn, the lender could foreclose on your home; therefore, it’s important to act fast if you foresee a problem. Reach out to the lender to understand your options, and consider refinancing to lower your rate or change your payment terms.

Before you open a HELOC, you might look for lenders that offer a fixed-rate option. This lets you lock in your APR when you draw from your equity, which protects your loan from rising interest rates and can make long-term financial planning a little easier.

Is it better to get a home equity loan or line of credit?

That depends on your financial situation and needs. A HELOC behaves like a revolving line of credit, letting you tap your home’s value in the amount you need as you need it. A home equity loan works more like a conventional loan, with a lump-sum withdrawal that’s paid back in installments.

HELOCs typically have variable interest rates, while home equity loans are usually issued with a fixed interest rate. This can save you from a future payment shock if interest rates rise. Work with your lender to decide which option is best for your financing needs.

Frequently asked questions

A home equity line of credit, or HELOC, is a type of second mortgage that lets you borrow against your home equity. Somewhat like with a credit card, you use money from the HELOC as needed, then pay it back over time.

With a HELOC, instead of borrowing a lump sum, you borrow money when you need it. Though your total credit line may be substantial, you only pay interest on the funds you actually use. HELOCs generally have adjustable interest rates, so HELOC rates fluctuate along with the market.

How is a HELOC paid back?

A HELOC has two phases, known as the draw period and the repayment period. During the draw period, you borrow money as needed, and required monthly payments generally just cover interest. In the repayment period, you can no longer borrow money, and you'll pay back both the principal and the interest.

Is HELOC interest tax deductible?

You may be able to claim a tax deduction on your HELOC interest if you used the loan for home improvements. The IRS sets annual limits that vary depending on whether you're single, head of household or filing jointly, and you'll have to itemize your deductions in order to take advantage of this one.

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